Industry giants support more regulation

Soros, John Paulson call for limits on leverage, financial engineering

By

AlistairBarr

SAN FRANCISCO (MarketWatch) -- Top hedge fund managers told Congress on Thursday that they support more regulation of financial markets, including closer supervision of their own $1.7 trillion industry.

Still, they said investment banks were more to blame for the current crisis and proposed limits on leverage and financial engineering across the financial-services industry.

The comments may revive a failed effort from earlier this decade to force hedge fund managers to register as investment advisers with the Securities and Exchange Commission. Indeed, Sen. Chuck Grassley said Thursday that he plans to re-introduce such legislation next year.

Hedge funds have suffered record losses this year as collateral calls from brokers, investor redemptions and a temporary ban on short selling of financial stocks up-ended many strategies. The market slump in recent months and a jump in volatility may have been partly driven by this industry turmoil. See full story.

'Decimated'

"Hedge funds were also an integral part of the bubble," said George Soros, chairman of Soros Fund Management LLC, one of the oldest and most successful hedge fund firms.

"But the bubble has now burst and hedge funds will be decimated," he added in prepared testimony before the U.S. House of Representatives Committee on Oversight and Government Reform. "I would guess that the amount of money they manage will shrink by between 50% and 75%."

Soros proposed bringing back variable margin requirements and minimum capital requirements that were used in the 1950's and 1960's to control the amount of leverage, or borrowed money, market participants can use.

"Sophisticated financial engineering," such as collateralized debt obligations and credit-default swaps, can make it almost impossible to gauge appropriate margin and capital requirements, he explained.

That means financial engineering must also be regulated and new products should be registered and approved by regulators before they can be used, Soros added.

The U.S. Federal Reserve and other regulators "abdicated" their responsibility to regulate because they thought that financial markets could correct their own excesses, Soros continued.

"The severity and amplitude of the crisis provides convincing evidence that there is something fundamentally wrong with this prevailing theory and with the approach to market regulation that has gone with it," he concluded.

Solvency

John Paulson, founder of $36 billion hedge fund firm Paulson & Co., blamed the crisis on the weak solvency of financial institutions, noting that the largest ten U.S. banks are leveraged 30 times.

He supported the Treasury Department's recent investment in banks, but said the program should be change to limit cash compensation and prevent the participating institutions from paying common stock dividends.

Bonuses should be paid in common stock to help replenish banks' capital and the terms of the government's investment need to be improved to increase taxpayer returns, he added.

Hedge fund regulation

James Simons, head of Renaissance Technologies LLC, said hedge funds didn't contribute to the current crisis.

He partly blamed the SEC and the Federal Reserve for allowing investment banks and brokerage firms to regulate themselves. That led those firms to use excessive leverage, he argued.

Hedge funds could be required to report their positions to "an appropriate regulator," he proposed.

The Federal Reserve Bank of New York, or similar authority, could then review that information on an aggregated basis and recommend action if needed, Simons explained.

Still, he said information like this from individual hedge fund firms shouldn't be disclosed to the public because retail investors might trade based on misunderstandings of the data.

Simons also argued that hedge fund compensation doesn't encourage excessive risk taking. Managers earn performance fees equal to 20% to 25% of annual profits, but if they lose money, they have to make it back before such fees kick in again.

Hedge fund compensation has also been criticized because performance fees are taxed at a lower rate than income. But Simons said that such arrangements are standard in all partnerships, including those in manufacturing, services, real estate and natural resources.

"If it is good public policy to alter that treatment, it should apply across the board to all types of partnerships, not simply to hedge funds," he added.

Philip Falcone, co-Founder of Harbinger Capital Partners, said he also supports some more government regulation requiring more public disclosure and transparency for hedge funds.

CDS

He also said he supports the creation of a public exchange or clearinghouse for derivatives, especially credit-default swaps, or CDS.

CDS are a type of derivative contract that insures fixed-income investors against defaults. There's an estimated $55 trillion of outstanding notional contracts, sparking concern that the collapse of a major CDS market participant could trigger more failures, Ken Griffin, founder of $15 billion hedge fund firm Citadel Investment Group, said.

The creation of central clearinghouses to guarantee CDS trades would reduce such systemic risk. Regulators would get greater transparency too, Griffin added.

Citadel and the CME Group
CME, -0.10%
have set up a clearinghouse for CDS in recent months, he noted.

Intraday Data provided by SIX Financial Information and subject to terms of use. Historical and current end-of-day data provided by SIX Financial Information. All quotes are in local exchange time. Real-time last sale data for U.S. stock quotes reflect trades reported through Nasdaq only. Intraday data delayed at least 15 minutes or per exchange requirements.